Is The Era Of ‘Credit Inflation’ Over: Do You Need To Change Investment Strategies

Is the era of “credit inflation” over?

Is the U.S. economy going back to a world in which consumer price inflation becomes the enemy once again?

Up until 2020, the increase in stock prices, the increase in housing prices, and the increase in commodity prices, as three examples, became the space where prices rose and rose and rose.

Consumer prices, for example, between the time of the Great Recession and the Covid-19 pandemic rose only modestly.

From the end of the Great Recession until the beginning of 2020, the rate of consumer price inflation was about a 2.3 percent compound rate of increase.

This was hardly considered to be inflation at all, given how mild price increases were during this period of time.

And, at 2.3 percent, the rate of inflation was very close to what the Federal Reserve had set out as its goal during this period.

The thing about this period of expansion that was of a little concern was that the compound rate of growth of real GDP was about 2.2 percent. Many analysts wanted the growth rate of the economy to be somewhat higher than 2.2 percent.

But, economically, it was a good time.

The Foundation Of “Credit Inflation”

To me, the government’s approach to economic policy-making during most of the last forty years of the twentieth century I titled “credit inflation.”

Early in the 1960s, the federal government, under the leadership of first President John F. Kennedy, and then under the leadership of Lyndon B. Johnson, worked to develop new economic policies to “get America growing again.”

The foundation for their approach was the “new” (at the time) economic thinking of economist John Maynard Keynes, and put a lot of emphasis upon government budget policy.

As the “sixties” moved along, the work that was being done included the narrative of the “Phillips Curve,” which argued that there was a tradeoff in the economy between getting lower rates of unemployment with a little bit of extra inflation. This tradeoff was just an empirical relationship, but one that seemed to be relatively stationary.

The government policy that came out of this work argued that the government could stimulate the economy through deficit spending supported by a sufficient supply of money. The key was the fiscal policy; the support was the accompanying monetary policy.

Economists argued at the time that this was an inflationary scheme and would end up creating more and more inflation. That is, if, at the start, the government could stimulate the economy, and reduce unemployment by a little bit, then the tradeoff could be shown.

The question concerned whether or not the relationship would stay stable.

Noted economist Milton Friedman, for example, argued that the statistical relationship would not remain constant. Higher actual inflation would cause “expected” inflation to rise, altering the Phillips Curve trade-off.

This reality represented the start of credit inflation.

Fighting Inflation

So, the Johnson administration got the program started, but the “prudent” deficits that were needed to start the policy effort were put aside as the Johnson administration began to spend more and more funds to support the growing military commitment to the Viet Nam War.

Inflation took off. President Nixon initiated a Wage-Price Freeze in 1971 and kicked off almost a decade of inflation fighting.

The culmination of this period came around 1980, as Paul Volcker, then chairman of the Federal Reserve System, stepped up and broke the inflationary cycle.

For someone wanting a good review of this period, check out the new book by former Fed chair Ben Bernanke, titled “21st Century Monetary Policy,” (W.W. Norton & Co.: 2022).

Anyway, in the early 1980s, inflation was brought under control.

This is when “credit inflation” really took control.

Whereas economic units observed that rising consumer prices were not looked on favorably and would draw the eyes of the policymakers, asset price increases did not get the same attention, and, by the way, rising stock prices, rising house prices, and rising commodity prices created a wealth effect that the wealthy could achieve, one that seemed to be a lot less risky than other means of earning a return.

So, in the 1980s and 1990s, more and more of the stimulus money the government pumped into the economy was directed toward the financial sector of the economy and not toward the real sector, the one that produced goods and services.

This was, and is, credit inflation. And, since the rise in stock prices, housing prices, and commodity prices seemed to be relatively steady, the return investors got by investing their money this way, was a lot less risky,.

And, investment strategies changed. Because “credit inflation” resulted in markets increasing in price, not just “value” assets that had to be studied and identified, investors moved more and more into investment firms that invested in markets, rather than in individual stocks. A major shift took place in where investors put their money.

This trend grew and became even more important in the 2010s. Ben Bernanke, created a new approach for the Federal Reserve to stimulate the economy. Mr. Bernanke’s approach had its roots in the results produced by the Phillips Curve.

Mr. Bernanke wanted monetary policy to generate rising stock prices which would generate consumer wealth and this wealth would cause consumers to spend more, supporting economic growth.

Mr. Bernanke succeeded, and the economy grew as stock prices rose, but consumer prices did not. “Quantitative easing” seemed to work.

And, Mr. Bernanke’s book tells this story.

Covid-19

And, then the world changed. The Covid-19 pandemic spread and the smooth functioning economy disappeared. Things became choppy again, sectors went into disequilibrium, and overall the economy became very distorted.

The Federal Reserve pumped trillions of dollars into the economy, created an asset bubble, and worked to make sure that enough was done so that there would not be a “mistake” that took the economy to the side of market collapse.

The largesse of the Federal Reserve generated inflationary pressures, thought initially to be temporary, but have proven to be more permanent.

And, the inflation become bad enough that the Fed had to change courses and begin to fight the rising prices.

The Fed is now in the middle of a “quantitative tightening” battle to bring inflation back down to the 2.0 percent range.

But, this has ended the era of “credit inflation.”

Or, at least it has postponed the return of “credit inflation.”

But, this is where investors need to be very careful.

The period of “credit inflation” allowed investors to invest in the whole market.

Moving away from “credit inflation” would seem to mean that we are moving more into a “value” investing environment.

If so, then investors are really going to have to alter their thinking.

It would seem that there is enough information out there to cause the investor to begin asking questions about what the current market strategy should be.

We won’t know for sure for a while, but investors must be cautious picking an investment strategy going forward.